Paul Krugman has impressive credentials. He's a columnist for The New York Times and a professor of economics and international affairs at Princeton. He won the Nobel Prize in economics in 2008 for his work on New Trade Theory and New Economic Geography. And, as a little icing on the cake, he's been voted one of the world's top intellectuals.
As for me, well, I have an undergraduate degree in economics. So where do I get off disagreeing with such a shining light of the economics community? Well this is America, right?
What got me going
Last week, Krugman wrote a column for The New York Times called "Financial Reform 101." The subject is one that's near and dear to my heart, and something that I've mused on quite a bit.
It's a pretty heady topic, and Krugman tried to break it down and give an easier-to-understand perspective on what the main issues are and where most of the contention has arisen.
Specifically, Krugman focused on the disagreement over whether new regulations should focus on breaking up big banks like JPMorgan Chase (NYSE: JPM ) , Bank of America (NYSE: BAC ) , and Citigroup (NYSE: C ) or tightening the oversight of "shadow banking" participants like Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ) . Krugman comes down on the latter side of the reform rift.
A thumbs-up for this Nobel laureate
I'm right there with Krugman when it comes to the importance of putting tighter regulations on the shadow banking industry. Just last week, I penned an article explaining why it was so scary that financial institutions had taken on hefty amounts of highly short-term financing in the precrisis days.
Whether you ask me, Krugman, or many others who have been weighing in on the reform issue, there's a very clear need to make sure that regulators dig into this Wild West of banking. Unless you're looking forward to more distress in the future.
In his op-ed, Krugman proposed two ways to potentially defang this financial system pain point:
(a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage.
I agree wholeheartedly that both would help ratchet down risk in the financial system.
A thumbs-down for this Nobel laureate
But I can't say that I'm wholly on board with Krugman's view of the financial world. Framing the whole thing as a debate between ending "too big to fail" and regulating shadow banking makes financial reform sound like an either/or issue. I don't see why that has to be the case.
While regulating shadow banking is a very crucial issue -- perhaps the most crucial issue -- the fact that our financial system has been held hostage by a cartel of massive banking institutions isn't doing us any favors. But Krugman doesn't even think this is something we should worry about:
Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.
Sure, if Fifth Third (Nasdaq: FITB ) , BB&T, and a wave of other regional banks suddenly started failing all at once, it would be a big problem for the system. However, when you have massive, too-big-to-fail institutions running around, all you need is one AIG (NYSE: AIG ) doing massively stupid things to threaten a financial meltdown.
As I've pointed out in the past, there may not even be a good reason to have gigantic banks in the mix since most research seems to show that there are no additional scale benefits beyond a certain (rather small) size.
Yet another wrong approach for reform
All in all, I tend to agree with a lot of what Krugman has to say. However, I think it's a mistake to pit two very important areas of reform against each other. Go ahead and call me an idealist, but I'd like to see comprehensive reform, not "good enough" reform. To have a real shot at the former, I believe we need to tackle both too big to fail and shadow banking.
Now that I've gone and called out a Nobel laureate, why not go ahead and call me out? Scroll down to the comments section and share your thoughts on financial reform.
Jordan DiPietro recently warned readers that they may be throwing away money while investing for retirement. Now you can't say you weren't warned.
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